Tutorial 1

Financial Markets and Institutions,

Multiple Choice:
. IBM issues $200 million of new common stock. This transaction is an example of

A- Secondary Market
B- Money market
C- Primary market
D- Forward transaction

Answer: C

. The New Company issues $50 million of common stock in an IPO. This transaction is an example of

A- Primary market
B- Money market
C- Secondary market
D- Foreign exchange transaction

Answer: A

. IBM sells $5 million of GM preferred stock out of its marketable securities portfolio. This transaction is
an example of

A- Primary market
B- Capital market.
C- Secondary market
D- forward transaction

E- Answer: C

The Magellan Fund buys $100 million of previously issued IBM bonds. This transaction is an example of

A- Primary market
B- Capital market.
C- Secondary market
D- forward transaction

F- Answer: C
Prudential Insurance Co. sells $10 million of GM common stock. This transaction is an example of

A- Primary market
B- Capital market.
C- Secondary market
D- forward transaction

Answer: C

Classify the following financial instruments as money market securities or capital market securities:

a. Banker’s acceptance: Money market

b. Commercial paper: Money Market
c. corporate bonds: Capital Market
d. Mortgages: Capital Market

f. Negotiable certificates of deposit: Money Market

g. Repurchase agreements: Money Market

h. U.S. Treasury bills: Money Market

i. U.S. Treasury notes j. Federal funds: Capital Market

What are the different types of financial institutions? Include a description of the main services
offered by each.
Financial institutions consist of

Commercial banks - depository institutions whose major assets are: loans and major liabilities are
deposits. Commercial banks’ loans are broader in range, including consumer, commercial, and real
estate loans, than other depository institutions. Commercial banks’ liabilities include more non-deposit
sources of funds, such as subordinate notes and debentures, than other depository institutions.

Thrifts - depository institutions in the form of savings and loans, savings banks, and credit unions.
Thrifts generally perform services like commercial banks, but they tend to concentrate their loans in one
segment, such as real estate loans or consumer loans.

Insurance companies - financial institutions that protect individuals and corporations (policyholders)
from adverse events. Life insurance companies provide protection in the event of untimely death,
illness, and retirement. Property casualty insurance protects against personal injury and liability due to
accidents, theft, fire, etc.
Securities firms and investment banks - financial institutions that underwrite securities and engage in
related activities such as securities brokerage, securities trading, and making a market in which
securities can trade.

Finance companies - financial intermediaries that make loans to both individuals and businesses. Unlike
depository institutions, finance companies do not accept deposits but instead rely on short- and long-
term debt for funding.

Mutual funds and hedge funds - financial institutions that pool financial resources of individuals and
companies and invest those resources in diversified portfolios of asset.

How do financial institutions help individuals diversify their portfolio risks? Which financial
institution is best able to achieve this goal?
As long as the returns on different investments are not perfectly positively correlated, by spreading their
investments across a number of assets, FIs can diversify away significant amounts of their portfolio risk.
Thus, FIs can exploit the law of large numbers in making their investment decisions, whereas due to their
smaller wealth size, individual fund suppliers are constrained to holding relatively undiversified
portfolios. As a result, diversification allows an FI to predict more accurately its expected return and risk
on its investment portfolio so that it can credibly fulfill its promises to the suppliers of funds to provide
highly liquid claims with little price risk. As long as an FI is sufficiently large, to gain from
diversification and monitoring on the asset side of its balance sheet, its financial claims (it issues as
liabilities) are likely to be viewed as liquid and attractive to small savers, especially when compared to
direct investments in the capital market. A mutual fund invested in a diverse group of stocks and fixed
income securities will best provide diversification for an investor.

How do FIs reduce monitoring costs associated with the flow of funds from fund suppliers to
fund investors?

A suppler of funds who directly invests in a fund user’s financial claims faces a high cost of monitoring
the fund user’s actions in a timely and complete fashion after purchasing securities. One solution to this
problem is for many small investors to place their funds with a single FI serving as a broker between the
two parties. The FI groups the fund suppliers’ funds together and invests them in the direct or primary
financial claims issued by fund users. This aggregation of funds resolves a number of problems. First, the
“large” FI now has a much greater incentive to hire employees with superior skills and training in
monitoring. This expertise can be used to collect information and monitor the ultimate fund user’s actions
because the FI has far more at stake than any small individual fund supplier. Second, the monitoring
function performed by the FI alleviates the “free rider” problem that exists when small fund suppliers
leave it to each other to collect information and monitor a fund user. In an economic sense, fund suppliers
have appointed the financial institution as a delegated monitor to act on their behalf. For example, full-
service securities firms such as Morgan Stanley carry out investment research on new issues and make
investment recommendations for their retail clients (or investors), while commercial banks collect
deposits from fund suppliers and lend these funds to ultimate users such as corporations
 Determinants of Interest Rates

1- A particular security’s equilibrium rate of return is 8 percent. For all securities, the inflation risk
premium is 1.75 percent and the real risk-free rate is currently earning 3.25 percent. Your
broker has determined the following information about economic activity and Moore
Corporation bonds:

-Real risk-free rate = 2.25%

-Default risk premium = 1.15%

-Liquidity risk premium = 0.50%

-Maturity risk premium = 1.75%

a. What is the inflation premium?

IP = i* – RFR = 3.25% - 2.25% = 1.00%

b. What is the fair interest rate on Moore Corporation 30-year bonds?

ij* = 1.00% + 2.25% + 1.15% + 0.50% + 1.75% = 6.65%

2- Dakota Corporation's 15-year bonds have an equilibrium rate of return of 8 percent. For all
securities, the inflation premium is 1.75 % and the real risk-free rate is 3.50%. The security’s
liquidity risk premium is 0.25 % and the maturity risk premium is 0.85%. Security has no special
covenants. Calculate the bond’s default risk premium.

Answer

8.00% = 1.75% + 3.50% + DRP + 0.25% + 0.85%

=> DRP = 8.00% - (1.75% + 3.50% + 0.25% + 0.85%) = 1.65%

3- A two-year Treasury security currently earns 1.94 percent. Over the next two years, the real risk-
free rate is expected to be 1.00 percent per year and the inflation premium is expected to be
0.50 percent per year. Calculate the maturity risk premium on the two-year Treasury security.
Answer

1.94% = 0.50% + 1.00% + 0.00% + 0.00% + MP

=> MP = 1.94% - (0.50% + 1.00% + 0.00% + 0.00%) = 0.44%

4- Tom and Sue’s Flowers Inc.’s 15-year bonds are currently yielding a return of 8.25 percent. The
expected inflation premium is 2.25 percent annually and the real risk-free rate is expected to be
3.50 percent annually over the next 15 years. The default risk premium on Tom and Sue’s
Flowers’s bonds is 0.80 percent. The maturity risk premium is 0.75 percent on 5-year securities
and increases by 0.04 percent for each additional year to maturity. Calculate the liquidity risk
premium on Tom and Sue’s Flowers Inc.’s 15-year bonds.

Answer
. 8.25% = 2.25% + 3.50% + 0.80 + LRP + (0.75% + (0.04% × 10))

=> LRP = 8.25% - (2.25% + 3.50% + 0.80% + (0.75% + (0.04% × 10))) = 0.55%

5- Nikki G’s Corporation’s 10-year bonds are currently yielding a return of 6.05 percent. The
expected inflation premium is 1.00 percent annually and the real risk-free rate is expected to be
2.10 percent annually over the next 10 years. The liquidity risk premium on Nikki G’s bonds is
0.25 percent. The maturity risk premium is 0.10 percent on 2-year securities and increases by
0.05 percent for each additional year to maturity. Calculate the default risk premium on Nikki
G’s 10-year bonds.

Answer

6.05% = 1.00% + 2.10% + DRP + 0.25% + (0.10% + (0.05% × 8)) =>

DRP = 6.05% - (1.00% + 2.10% + 0.25% + (0.10% + (0.05% × 8))) = 2.20%